Going for Break: Our Third Annual Tax Efficiency Scorecard

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Earlier this year, Procter & Gamble announced that it would buy the Clairol hair-care business of Bristol-Myers Squibb for $4.95 billion in cash, a significant premium over Bristol-Myers’s cost basis for the assets. In response, Standard & Poor’s and Dominion Bond Rating Service soon downgraded P&G’s credit ratings.

But these credit agencies ignored the tax benefits that P&G gained from the deal. In fact, because P&G paid a premium for Clairol, the value of the goodwill amortization deduction will improve P&G’s cash flow for the next 15 years. The tax consequences reduced the cost of the deal to P&G by $1 billion — or 20 percent. Yet Bristol-Myers presumably got more for Clairol than it would have if P&G received no such benefits. Neither P&G nor Bristol-Myers would comment.

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This transaction was accomplished courtesy of Section 338(h)10 of the U.S. tax code, and it is one that other firms besides P&G and Bristol-Myers are eyeing. Under Section 338(h)10, a company that makes an acquisition is entitled to write off goodwill against its taxable income for the next 15 years. That, to be sure, would also reduce reported earnings. But buyers are always interested in goodwill amortization for tax purposes, and they may be able to convince investors to ignore the resulting hit to earnings.

What’s more, the end of pooling-of-interest accounting will encourage more asset disposition of all kinds. While pooling made it easy for even the most aggressive acquirers to avoid earnings hits from goodwill, that applied only to acquisitions of entire companies. The rules also required companies to wait at least two years to sell assets. Starting last July 1, buyers are free to dispose of assets at any time.

Indeed, the accounting change may greatly reduce effective tax rates simply because in most cases goodwill will no longer be written off against earnings unless it is impaired. The average firm paid nearly 37 percent of its revenue in federal, state, and local taxes last year, up more than two percentage points from 1997, according to CFO’s Third Annual Tax Efficiency Scorecard.

Under the new rules, more companies will have less amortization inflating their effective tax rates. But with new freedom to do deals anytime as the economy weakens, companies will find themselves both freer and under increasing pressure to pursue synergies through asset disposals.

“The situation is changing,” says a tax expert who asks not to be identified, “because of new rules and the impact of a down economy.” The downturn helps explain why other moves may also gain currency these days. For example, companies that have losses abroad may want to designate their foreign subsidiaries as branches so that the parent can use the losses for tax purposes.

“We’re looking at everything,” says Sandy Peiser, vice president and tax manager of Raymond James Financial, an investment and brokerage firm based in St. Petersburg, Florida. Currently in Peiser’s sights are tax credits for training and business development at the local and state levels, which are often connected with so-called enterprise zones. Such credits require a considerable amount of Peiser’s attention, in part because of the significant differences in each jurisdiction’s terms for qualifying. “They don’t all play by the same rules,” he notes. But Raymond James, for one, finds the rules worth mastering, since the company has offices in all 50 states.

Even companies that are relatively immune from recession are turning more to tax savings these days. “We’re leaving no stone unturned,” says Dave Bernard, vice president of tax for Kimberly-Clark, a major producer of basic household products. Having taken measures to maximize income in foreign jurisdictions with lower tax rates, for example, the company has been busy striking so-called advance pricing agreements with local and U.S. tax authorities. The agreements are designed to make sure that transfer pricing policies, which allow the company to take maximum advantage of tax losses, won’t run afoul of either authority. Kimberly-Clark now has five or six such agreements in place, says Bernard.

The company is also looking to buy from third parties tax credits for which it cannot itself qualify. These include credits for the development of low-income housing and synthetic fuels, neither of which are directly related to its business. “We look at every dollar of tax basis and every dollar of tax loss as a potential tax asset,” says Bernard.

The tables that follow should help Bernard and other tax directors get a better handle on where they stand in relation to their peers. Included is data for the five leaders in 40 industries for the three years ending with fiscal 2000.

Methodology for Computing Effective Tax Rates

As in years past, KPMG LLP compiled this year’s Tax Efficiency Scorecard by reviewing income statement data for the Fortune 1,000. It eliminated industries that were either too small to provide a representative sample or of little relevance to most readers; divided the remaining companies into 40 industry groups; tossed out those that didn’t post a cumulative profit for the three-year period from 1998 through 2000 or posted losses in two out of those three years; reviewed the footnotes to the financial statements of each qualifying company to verify discrepancies between the data supplied by Standard & Poor’s Compustat and the companies’ annual reports, and in some cases to eliminate companies where unusual circumstances prevented apples-to-apples comparisons; and sorted the survivors within their industry groups by the lowest effective tax rate. Note that the results do not reflect the amount of cash a company paid in taxes, which is often quite different from the tax provision on its income statement.

• Sample Size: Number of companies in the industry sample.• 3-Year Average Revenue: Average annual revenue divided by the number of companies in the industry sample.• 3-Year Average PBT: Average annual profit before tax (PBT) divided by the number of companies in the industry sample.• 3-Year Weighted Average Effective Tax Rate (ETR): 1998—2000 total tax provision divided by 1998—2000 total PBT.• Ranking Among Industries: Rank of each industry’s 3-year weighted average ETR in ascending order.• 2000 ETR: 2000 total tax provision divided by 2000 total PBT.• 1999 ETR: 1999 total tax provision divided by 1999 total PBT.• 1998 ETR: 1998 total tax provision divided by 1998 total PBT.• ETR % Change: The difference between the 2000 and 1998 ETRs divided by 1998 ETR.• 3-Year Weighted Average Cash Rate: 1998-2000 cash taxes paid divided by 1998—2000 total PBT.• 3-Year Weighted Average U.S. Revenue: 1998—2000 U.S. revenue divided by the sum of 1998—2000 U.S. and foreign revenue.• 3-Year Weighted Average Non-U.S. Revenue: 1998—2000 non-U.S. revenue divided by the sum of 1998—2000 U.S. and non-U.S. revenue.